Thursday, 13 December 2012

Open and shut

FDI in retail will bring competition to non-tradable services,
and make Indian firms globally competitive

India removed barriers to trade in goods in the 1990s. Removing
protection brought global competition and raised productivity. But
introducing global competition in services is harder. In certain
services that are tradable, like legal or financial services, the
removal of trade barriers can introduce competition and increase
productivity. But these often involve complicated and time-consuming
multilateral negotiations. In other services that are not tradable,
like retail trade, global competition can be introduced and
improvement in productivity can be achieved by opening up the sector
to foreign direct investment.

Reducing protection in the market for goods, cutting custom duties
on imports, and removing quotas and other restrictions on trade raises
few questions today. The case for trade liberalisation in goods is
well understood by now. Trade liberalisation exposes local firms to
global competition. Domestic firms have to innovate, produce better
products, improve their technology, and reduce costs of production
when imported products enter domestic markets. Under such pressures,
these firms become more productive. These productive firms become
exporters. The most productive firms invest abroad. Both face further
competition in foreign markets and productivity growth continues. In
contrast to the pre-trade liberalisation regime, productivity in the
economy is higher and keeps growing. This results in higher growth of
incomes and standards of living in the country. Trade liberalisation
has transformed many countries, such as those in East Asia.

India has also seen the benefits of reducing protection in goods
markets. Trade liberalisation in the 1990s, which continued into the
early 2000s, saw Indian industry transform. At the same time that
barriers to trade were reduced, domestic restrictions on production
imposed through the licence raj were removed so that incumbents, who
had long outlived the infant industry stage, faced both domestic and
global competition. The FDI regime in manufacturing was, however,
accommodated continued support to Indian industry. While opening up
manufacturing to trade and to foreign investment, policy encouraged
joint ventures that gave an advantage to Indian firms by not allowing
100 per cent FDI. The limit on how much could be invested by a
foreigner was only slowly raised over the years. Clauses such as Press
Note 18, which did not permit the foreign investor to start new
ventures without the permission of its domestic partner, were put in
place to support Indian firms. The result of higher competition and a
carefully calibrated policy environment has been to create Indian
firms that are strong enough now to become multinationals. Without the
process of reducing tariff barriers and removing protection for Indian
industry, Indian firms would not have ended up being so strong in
world markets today. More than 300 Indian firms are multinationals
now. They compete successfully with foreign companies on their
turf.

Just as reduction in trade barriers brought competition to goods
markets, tradable services can also be opened up to competition if the
barriers are brought down. Services trade was growing rapidly before
the global financial crisis, but it still represented a small share of
the international economy. One reason for this, as a study by
Sebastien Miroudot et al suggests, was high trade costs. In the goods
markets, these costs include tariffs, non-tariff measures, transport
charges, "behind-the-border" regulatory measures, and frictions
related to geographical, cultural, and institutional differences. In
the services sectors, trade costs are largely related to regulatory
measures that either create entry barriers or increase the cost
burdens faced by firms, in addition to geographical, cultural, and
institutional differences. According to the World Bank's Services
Trade Restrictions Database, which measures protectionism in services
across the world, there are huge barriers to services trade. The
absolute levels of trade costs in services are very high in the major
economies; over 100 per cent ad valorem in all cases, and over 200 per
cent for India. Trade costs in services markets are much higher than
for goods and a multiple of two or even three times is sometimes
seen. Trade costs in services can, therefore, be reduced by reducing
trade restrictions.

Any reduction in trade restrictions in services is, however, likely
to involve long and complicated multilateral negotiations. In many
cases, improvement in domestic regulation, such as in finance, will be
a precondition before trade in services is opened up. Competition, and
the consequent higher productivity in tradable services, may therefore
still take a while.

But for non-tradable services, such as retail trade, there are no
such trade barriers to be removed or difficult negotiations to be
held. This can be achieved by opening up these sectors to FDI. Sectors
of the economy whose productivity is low can benefit from this. For
instance, though modern retail has grown in India, especially in the
last decade, the sector remains largely informal and this growth has
been limited. Unlike trade in goods, the advantages of FDI in retail,
such as better technology, management and the move to a modern,
formal, tax-paying sector, will probably unfold slowly. There are many
hurdles retail businesses have to cross before investment spending can
begin.

The government might have supported FDI in retail to make a
political point, to send a signal to investors, or to bring in foreign
capital and prevent rupee depreciation. But whatever the reasons, this
move takes India a step closer to increasing competition and achieving
higher productivity in non-tradable services. With 51 per cent, rather
than 100 per cent, FDI being allowed in multi-brand retail, large
Indian companies that are either already in the business or have
planned to enter it, are likely beneficiaries. Chances are, in twenty
years it will be Indian companies running retail stores in towns and
cities all over the world.